DataTrek Research analysts observe that many investors are mystified as to why the Federal Reserve would want to cut near-term interest rates in the midst of a strong U.S. economy.
They argue that you need to look no further than the Fed’s latest Beige Book for an explanation.
The biggest takeaway from the latest report is rising concerns about trade wars from the Fed’s business contacts across the country.
Here are DataTrek’s views, edited:
Given that the Beige Book is released two weeks prior to central bank meetings, this report will be top of mind for the Fed’s rate-setting committee when making its monetary policy decisions on July 31.
Fed Chairman Jerome Powell has been vocal about the importance of this report. The bottom line here is that it’s not a matter of “if,” but rather “how much,” the Fed will cut.
Fed Funds futures have been spot-on relative to the Fed’s rate policy this year. So here are the odds through Wednesday:
- July: Odds of a 25-basis-point cut in two weeks are 61%, down from 72.9% Tuesday. Why? Following the release of Wednesday’s Beige Book report, odds for a 50-basis-point cut rose to 39% from 27.1% one day ago.
- December: Odds that Fed Funds will be 25-50 basis points lower than Wednesday are 35.9%, down from 44.2% Tuesday. Chances they will be 75 to +100 basis points lower are 64.2%, up from 55.9% Tuesday.
So, what about the state of the U.S. economy over the last six weeks pushed Fed Funds futures to think the central bank will be more accommodative?
Here’s what the Beige Book says …
The July report shows U.S. economic activity “continued to expand at a modest pace overall from mid-May through early July.”
On the plus side, retail sales “increased slightly overall” … tourism activity was “broadly solid” … home sales “picked up somewhat” … higher demand for loans was “broad-based” … nonfinancial services activity continued to rise … and nonresidential construction activity was mostly strong or rose.
On the downside, vehicle sales, residential construction and manufacturing were mostly “flat.” Agricultural output also “declined modestly” due to heavy rain, and oil and gas production “fell somewhat.”
Overall, the outlook “generally was positive for the coming months, with expectations of continued modest growth.”
#2: Despite overall optimism looking forward, worries over trade uncertainty remain “widespread.” Mentions of tariffs and trade policy uncertainty were “major issues” — particularly for manufacturers, which experienced both higher input costs and “weakened demand for their products.”
Here are a few examples:
- In Boston: “A manufacturer of electronic components said it had laid people off as a result of the tariffs, with headcount declining by about 10%. For example, the firm had moved an assembly line from the U.S. to Germany because most of the components in the product came from China and making the product in Germany allowed them to avoid the tariffs.”
- In Philadelphia: “Most firms continued to note some negative effects from tariffs, including higher costs, lower profit margins, greater uncertainty, and lower capital expenditures on new industrial capacity. Food processors noted relief that tariffs were not imposed on imports from Mexico.”
- In Richmond: “Several contacts continued to report challenges with tariffs and the trade environment … A West Virginia rubber manufacturer attributed a drop in business from Chinese customers to the trade wars … A North Carolina retailer reported rising prices from suppliers, which was attributed to tariffs.”
#3: Employment “grew at a modest pace, slightly slower than the previous reporting period” … but labor markets “remained tight.”
Employers continued to struggle to find qualified workers, an ongoing issue amid “worker shortages across most sectors.” Interestingly, “some manufacturing and information technology firms in the Northeast reduced their number of workers.”
As for wages, they grew at a “modest-to-moderate” pace, although some contacts “emphasized significant increases in entry-level wages.” Most districts also said employers expanded benefits packages.
As for the other side of the Fed’s dual mandate (which is actually a trio of goals: to promote maximum employment, stable prices and moderate long-term rates), price inflation was “stable to down slightly.”
Tariffs contributed to some increases in input costs, especially for the manufacturing sector.
The upshot: The economy continues to expand — albeit modestly — and business contacts maintain a positive outlook.
Even still, mentions of the word “uncertain” occurred between 14 to 17 times in reports from January through April, and has risen to 21 and 23 references in the latest two reports respectively — mostly related to trade.
DataTrek analysts conclude that tariffs clearly continue to weigh on sentiment and capital-expenditure plans, and that is why the Fed will likely cut rates by 25 basis points later this month.
Bad Moon Rising
Couple of observations from Jason Goepfert of SentimenTrader.com that can help put today’s markets into context …
— Buck Moon. There was a Buck Moon on Tuesday, which is a full moon in July. These have not been good omens for stocks. After all — over the past 20 years and five full moons in July — if the S&P 500 was trading at or near a high, it fell over the next one and two months.
I see you shrugging your shoulders. Who cares about the moon, right? Well, a lot of sentiment analysts believe there is a connection between full moons and emotional market action.
The gravitational pull of the moon causes massive movement in ocean tides, so why shouldn’t they have an effect on the emotions of people who are 60% made of water.
(By the way, the brain and heart are 73% water and the lungs are 83% water.)
— Index highs when earnings are negative. When the S&P 500 is at or near a new high … but earnings for the companies in the index are expected to be lower than the same quarter a year prior … the market has tended to falter over the following few months and return only 4% over the next year.
There were 17 instances of this scenario, including the present, since 1950, Goepfert reports. The last example was July 15, 2016. The S&P 500 was down 1.7% over the next two months.
It seems that the market will whistle past the graveyard for just a week or two before stumbling.
In the meantime, sit tight in your favorite stocks. For my subscribers, Microsoft is one of those favorites. It just hit an all-time high and we’re tracking a sweet 100% gain … so far.
But while it’s great to watch Mister Softee reinvent itself every year, what I’m really excited about are all the smaller, lesser-known tech stocks that can offer even bigger profit potential. See what I mean here.
Jon D. Markman